By Robert Campbell
NEW YORK, May 29 (Reuters) - The North American oil trade is moving to a new, more intensely regional phase. For the next year, the main pressure point will not be at Cushing, Oklahoma, but rather in regional markets. Physical, not paper trades will be the most profitable.
Pipeline capacity at Cushing, which was formerly in deficit, has now reached a point where there is more capacity available going to more profitable markets than there is inbound supply.
The large overhang of inventories at the price settlement point for West Texas Intermediate on the New York Mercantile Exchange will be drawn down to make up the difference in supply and demand balances until major new sources of supply, such as Enbridge’s Flanagan South pipeline, or the Pony Express pipeline conversion, start up in late 2014.
By and large, this scenario is now well known and forms the basis for traders’ assumptions that the spread between Brent futures and West Texas Intermediate crude will continue to narrow as the stock overhang at Cushing is drawn down.
But that does not mean that the North American oil market has fully worked through the implications of the shale oil revolution. Far from it. Infrastructure at Cushing may be less problematic for the next 12-18 months but problems elsewhere are mounting.
For instance, the narrowing Brent-WTI spread has taken some of the wind out of the crude-by-rail movement in North Dakota, the origination point for some 500,000 barrels per day of rail-shipped crude.
Current market prices make it more attractive now for some Bakken producers to ship crude on the Enbridge North Dakota pipeline system that connects with the main Enbridge system at Clearbrook, Minnesota.
But these barrels cannot find their way into Cushing, at least directly. Pipeline space that would link the Enbridge North Dakota lines with the WTI delivery point in Oklahoma has not grown. The upshot is Bakken barrels entering the northern Midwestern pipeline market are coming into direct competition with Canadian light sweet crude.
BAKKEN TAKES CUSHING‘S PLACE
People think of Canadian oil production as being exclusively heavy, sour oil sands crude but the truth is the country is a major producer of conventional crude.
Non-oil sands light and medium crude output from Western Canada was expected to reach 743,000 bpd this year in the Canadian Association of Petroleum Producers’ latest forecast, published in June 2012. Approximately 360,000 bpd of this oil was expected to be refined in Canadian plants, leaving a substantial amount that has to be exported to the Midwestern United States.
These are the barrels now coming into direct competition with Bakken crude volumes. And like the Bakken grades, they are largely locked into their current pipeline networks. Rail offtake in Canada is far less developed than in North Dakota so the fight will largely come down to price.
As more Bakken barrels fight with Canadian conventional crude for market space both sides will have to cut their prices to find buyers. Indeed, the ultimate effect of higher Bakken deliveries into the pipeline network will be to drive down Bakken prices in North Dakota to the point that rail shipments once again become more attractive than pipeline deliveries.
This is because a fight between Canadian and Bakken crude is ultimately a zero-sum game. Prices must decline to the point where the surplus can be used to displace non-North American barrels somewhere else.
So because Bakken has the most developed rail infrastructure it is effectively the swing production in the North America, especially now as Cushing is in a structural supply deficit. Midwestern oil production imbalances were previously absorbed by Cushing storage.
Now the more likely scenario is that Bakken prices in North Dakota will be the swing factor, falling in response to oversupply to the point that rail movements to other regions make sense.
Beyond this near-term dynamic lies a further development in the North American oil story. Thus far dislocations in price have been mainly due to severe infrastructure deficits. Major sources of new oil output are cropping up in places, like North Dakota, that are far from much of the existing distribution network.
As regional interconnectivity increases the focus of trade will shift back towards the relative values of different crude oils. So while infrastructure deficits lead to pricing on distressed levels to allow stranded barrels to clear, once transportation bottlenecks are erased the market will still have to deal with quality concerns, particularly as burgeoning North American output must increasingly displace foreign imports from outside the light sweet universe.
Thus far we are not really at this point. The relative stability of cash crude pricing on the Gulf Coast suggests this region, for instance, is so far absorbing rising output of very light crude oil and condensate from the Eagle Ford formation, as well as increased inbound supplies of North Dakotan light crude, fairly well.
Blending opportunities with heavy crude remain sufficiently attractive to not for domestic producers into heavy discounts to find buyers. But there may be a limit to blending at non-distressed prices.
This is the real danger sign for North American oil producers. If outlet markets away from the flooded interior begin to enforce distressed pricing as a way to clear surplus production, then a race to the bottom will have truly begun.
Until then, the Bakken swing will mark more the relative supply and demand balance in the Midwest.